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A Short Primer On Tax Treaties: Canada Tax Treaties Spotlight

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In addition to the U.S. and foreign statutory rules for the taxation of foreign income of U.S. persons and U.S. income of foreign persons, bilateral income tax treaties limit the amount of income tax that may be imposed by one treaty partner on residents of the other treaty partner. Treaties also contain provisions governing the creditability of taxes imposed by the treaty country in which income was earned in computing the amount of tax owed to the other country by its residents with respect to such income. Treaties further provide procedures under which inconsistent positions taken by the treaty countries with respect to a single item of income or deduction may be mutually resolved by the two countries.

The preferred tax treaty policies of the United States have been expressed from time to time in model treaties and agreements. The Organization for Economic Cooperation and Development (the “OECD”) also has published model tax treaties. In addition, the United Nations has published a model treaty for use between developed and developing countries. The Treasury Department, which together with the State Department is responsible for negotiating tax treaties. The OECD has published a model income tax treaty (“the OECD model”). The United Nations has also published a model income tax treaty (“the U.N. model”).

Many U.S. income tax treaties currently in effect diverge in one or more respects from the U.S. model. These divergences may reflect the age of a particular treaty or the particular balance of interests between the United States and the treaty partner. Other countries’ preferred tax treaty policies may differ from those of the United States, depending on their internal tax laws and depending upon the balance of investment and trade flows between those countries and their potential treaty partners. For example, certain capital importing countries may be interested in imposing relatively high tax rates on interest, royalties, and personal property rents paid to residents of the other treaty country. Consequently, treaties with such countries may have higher withholding rates on dividends, interest, royalties, and personal property rents. As another example, the other country may demand other concessions in exchange for agreeing to requested U.S. terms. Countries that impose income tax on certain local business operations at a relatively low rate (or a zero rate) in order to attract manufacturing capital may seek to enter into “tax-sparing” treaties with capital exporting countries. In other words, the country may seek to enter into treaties under which the capital exporting country gives up its tax on the income of its residents derived from sources in the first country, regardless of the extent to which the first country has imposed tax with respect to that income. While other capital exporting countries have agreed to such treaties, the United States has rejected proposals by certain foreign countries to enter into such tax-sparing arrangements.

The OECD, the U.N., and the U.S. models reflect a standardization of terms that serves as a useful starting point in treaty negotiations. However, issues may arise between the United States and a particular country that of necessity cannot be addressed with a model provision. Because a treaty functions as a bridge between two actual tax systems, one or both of the parties to the negotiations may seek to diverge from the models to account for specific features of a particular tax system.

Model Income Tax Treaty Provisions

Several significant features of the model income tax treaties are described briefly below.

Residence

The U.S. model generally treats as a resident of a treaty country any person who, under the laws of that country, is liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other similar criterion. However, the concept of resident excludes any person who is liable to tax in a country solely in respect of income from sources in that country or of profits attributable to a permanent establishment in that country.

Business Profits Attributable To A permanent Establishment

Under the U.S. model, one treaty country may not tax the business profits of an enterprise of a qualified resident of the other treaty country, unless the enterprise carries on business in the first country through a permanent establishment situated there. In that case, the business profits of the enterprise may be taxed in the first country on profits that are attributable to that permanent establishment. The U.S. model describes in detail the characteristics relevant to determine whether a place of business is a permanent establishment. The term includes a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, or any other place of extraction of natural resources.

The U.S. model provides that the business profits to be attributed to the permanent establishment include only the profits derived from the assets or activities of the permanent establishment. The U.N. model adds a limited “force of attraction rule” which would allow the country in which the permanent establishment is located to attribute to the permanent establishment sales in that country of goods or merchandise of the same or similar kind as those sold through the permanent establishment, and to attribute to the permanent establishment other business activities carried on in that country of the same or similar kind as those effected through the permanent establishment.

The U.S., OECD, and U.N. models expressly provide for the allocation of worldwide executive and general administrative expenses in determining business profits attributable to a permanent establishment. The U.S. model also provides for the allocation of research and development expenses, interest, and other expenses incurred for the purposes of the enterprise as a whole (or the part of the enterprise that includes the permanent establishment).

Dividends

The U.S. model permits taxation of dividends by the residence country of the payor, but limits the rate of such tax in cases in which the dividends are beneficially owned by a resident of the other treaty country. In such cases, the U.S. model allows not more than a 5-percent gross-basis tax if the beneficial owner is a company that owns directly at least 10 percent of the payor’s voting stock, and not more than a 15-percent gross-basis tax in any other case. Under the OECD model, the 5-percent rate is not available unless the beneficial owner of the dividends is a company other than a partnership that holds directly at least 25 percent of the capital of the dividend payor. The U.N. model expressly leaves to case-by-case bilateral negotiation the particular percentage limit to be imposed on source-country taxation of dividends.

Interest And Royalties

The U.S. model generally allows no tax to be imposed by a treaty country on interest or royalties arising in that country and beneficially owned by a resident of the other treaty country. By contrast, the OECD model would permit up to 10-percent gross-basis taxation of interest by the treaty country in which the interest arises. The U.N. model expressly leaves to case-by-case bilateral negotiation the particular percentage limit to be imposed on source-country taxation of interest or royalties.

Other Income

The U.S. model provides that items of income beneficially owned by a resident of a treaty country, wherever arising, that are not dealt with in the articles of the treaty are taxable only by the recipient’s country of residence. By contrast, the U.N. model states that items of income of a resident of a treaty country not dealt with in the other treaty articles and arising in the other treaty country may also be taxed in that other country.

Relief From Double taxation

The U.S. model obligates the United States to allow its residents and citizens as a credit against U.S. income tax: (a) income taxes paid or accrued to the treaty country by the U.S. person, and (b) in the case of a U.S. company owning at least 10 percent of the voting stock of a company resident in the treaty country, and from which the U.S. company receives dividends, the treaty country income tax paid or accrued by or on behalf of the payor company with respect to the profits out of which the dividends are paid. However, the U.S. model preserves U.S. internal law by subjecting this right to the foreign tax credit to the provisions and limitations of U.S. law as it may be amended from time to time without changing the general principle of the model provision.

A standard article in treaties specifies the U.S. and foreign taxes covered by the treaty. The U.S. model provides that such covered taxes shall be considered income taxes for purposes of the credit article, and contemplates the possibility that such a tax might be creditable solely by reason of the treaty.

Nondiscrimination

The U.S. model provides that nationals of a treaty country, wherever they may reside, shall not be subjected in the other country to any taxation (or any requirement connected therewith) that is more burdensome than the taxation and connected requirements to which nationals of that other country in the same circumstances, particularly with respect to taxation on worldwide income, are or may be subjected. Similarly, the taxation of a permanent establishment or fixed base that an enterprise or resident of a treaty country has in the other country generally shall not be less favorably levied in the source country than the taxation levied on enterprises or residents of the source country carrying on the same activities. Further, an enterprise of a source country, the capital of which is wholly or partly owned or controlled by one or more residents of the other country, shall not be subjected in the source country to any taxation (or any requirement connected therewith) that is more burdensome than the taxation and connected requirements to which other similar source-country enterprises are or may be subjected. Finally, the U.S. model generally provides (subject to certain arm’s length standards) that interest, royalties, and other disbursements paid by a treaty country resident to a resident of the other country shall, for the purposes of determining the taxable profits of the payor, be deductible under the same conditions as if they had been paid to a resident of the source country.

Mutual Agreement Procedures

The U.S. model provides for a treaty country resident or national to obtain relief, from the competent authority of either treaty country, from actions of either or both countries that are considered to result in taxation in violation of the treaty. The U.S. model requires the competent authorities to endeavor to resolve such a case by mutual agreement where the home country authority cannot do so unilaterally.

The largest country in the Western Hemisphere, Canada is a parliamentary democracy consisting of ten provinces and three territories.

Its primary tax laws derive from the Income Tax Act (RSC 1985, c. 1, 5th Supp.), Excise Tax Act (RSC 1985, c. E-15) and other federal and provincial legislation.

Recent tax measures include 100% first-year deduction (capital cost allowance) for certain manufacturing and processing equipment, changes in treatment of derivative forward agreements, foreign affiliate dumping rules, transfer-pricing rules, and rules with respect to cross-border securities lending arrangements, employee stock options, and mutual fund trust redemptions.

Canadian corporations are generally subject to taxation on worldwide income.  Non-resident corporations are subject to tax on income derived from carrying on a business in Canada and certain capital gains.  Resident individuals are subject to tax on worldwide income; non-resident individuals are subject to tax on income from employment in Canada, as well as income from carrying on business in Canada and certain capital gains.

Effective July 1, 2020, Canada is a member of the United States-Mexico-Canada Agreement (CUSMA)

Treaty.

 Currency.

  • Canadian dollar (CAD)

Common Legal Entities.

  • Corporation, unlimited liability company, sole proprietorship, partnership, joint venture, trusts, and branches.

Tax Authorities.

  • Canada Revenue Agency (CRA) and provincial authorities

Tax Treaties.  

  • Canada is a signatory to 93 income tax treaties, as well as the OECD MLI.

Corporate Income Tax Rate.  

  • Federal rate of 15%, with provincial and territorial rates ranging from 11.5% to 16%.

Individual Tax Rate.  

  • Up to 33%.

Capital Gains Tax Rate.  

  • Fifty percent exclusion, less allowable capital losses, taxed at ordinary income tax rates.

Residence.

  • Corporate residence is based on incorporation in Canada or central management and control in Canada.
  • Individuals are classified as a tax resident if they reside in Canada or are ordinarily resident in Canada, with a presumptive test being satisfied where an individual spends at least 183 days in Canada during a calendar year.

Withholding Tax.

            Dividends.

  • 25 withholding on payments to nonresidents.

            Interest.

  • 25 withholding on payments to nonresidents.

            Royalties.

  • 25 withholding on payments to nonresidents.

Branch Profits Tax.

  • Canada imposes a 25% branch profits tax.

Transfer Pricing.

  • Canada employs an arm’s-length standard, with a “reasonable efforts exception.”  Canada has adopted Country-by-country reporting (CbCR) for certain multinational enterprise (MNE) groups, generally following BEPS action 13.  .

CFC Rules. Canadian residents are subject to a current tax on an allocable share of foreign accrual property income (“FAPI”) earned by a. controlled foreign affiliate.  Anti-avoidance rules may apply.

Thin Capitalization.  Yes.  Canada provides thin capitalization limitations on interest deduction to specified nonresident persons.

Inheritance/estate tax.  No.  However, certain gifts are deemed sales.  In addition, a deceased taxpayer is deemed to have disposed of property prior to death at fair market value.


National Income Taxes

Canada imposes a national income tax on the income of individuals and companies.  In addition, provincial taxes are imposed on the income from activity within the provinces.  Nonresidents are taxed on Canadian-source income. The Canadian corporate tax system attempts to alleviate the double taxation of income through the implementation of a modified imputation system, which provides a tax credit with respect to dividends paid by domestic corporations to individuals.

Individuals

Individuals resident in Canada are subject to tax on their worldwide income.  Each individual must separately compute his or her tax liability, and family members may not file joint income tax returns. Gross income is divided into several categories, including employment income, business income, property income, and capital gains.

Property income consists of passive income earned through investment activities.  In computing gross income, resident taxpayers determine their income and losses for each category separately.  All sources of income are then aggregated before the taxpayer calculates taxable income.  Individuals also are subject to an alternative minimum income tax.

Individual taxpayers are entitled to deductions for a limited number of personal expenses, including for childcare expenses incurred to allow the individual to work or obtain education.  Individuals may also claim a number of credits, which are calculated by multiplying an allowance by the lowest tax rate.

Dividends, interest, and royalties are subject to tax, and the expenses incurred to produce investment income generally are deductible.  Dividends paid by domestic companies are taxable at a reduced rate. An individual’s effective tax rate on dividends depends on the province and generally is equal to that on capital gains. The rate reduction is accomplished by means of an imputation tax credit under which a shareholder is permitted a credit on the grossed-up dividend.

The gross-up amount equals one-forth of the dividend and theoretically represents the corporate income subject to corporate-level tax. The dividend credit amount, which is based on the gross amount of the dividend, represents the corporate tax paid on the distributed dividend. One half of capital gains are included in income, and a Canadian resident is entitled to an exemption over his lifetime on gain from the disposition of either a qualifying farm or shares of a Canadian-controlled private corporation that uses substantially all its assets in carrying on an active business primarily in Canada.

Corporations

Corporations resident in Canada are taxable on their worldwide income from business income, property income, and capital gains.  Property income consists of passive income earned through investment activities. Business income is taxable at full rates, property income is generally taxable at full rates with certain exceptions for dividends, and 50 percent of capital gain is included in income.

Expenses are generally deductible to the extent they are reasonable and incurred for the purpose of gaining or producing income, and, if related to capital structure (i.e., an amount deducted with respect to an outlay, loss, or replacement of capital), to the extent the deduction is expressly permitted by the Income Tax Act. Expenses are not deductible if they are incurred for the purpose of gaining or producing exempt income or if they are incurred solely for the purpose of realizing capital gains. In general, financing expenses, royalties, and inter-corporate dividends are deductible. Interest expense that is on capital account is deductible only in accordance with statutory rules.

Canada levies taxes at both the individual and the shareholder level, and double taxation is partially eliminated through a modified imputation system. A notional dividend tax credit provides tax relief with respect to domestic dividends paid to individuals. This credit does not fully compensate for corporate tax paid in the case of active business income of a Canadian-controlled private corporation in excess of an annual limit, income earned by a publicly traded domestic corporation, income earned by a nonresident controlled corporation, or income earned by a publicly traded domestic corporation.

Corporate entities resident in Canada are generally subject to tax on their worldwide income at rates that depend on the status of the corporation and the type and location of income earned.  A corporation is considered to be a Canadian resident if it was incorporated in Canada or, if incorporated outside Canada, its central management and control is located in Canada.

Corporate groups are not permitted to file consolidated tax returns, but special rules govern the treatment of intra-group income. Dividends are includible in income, and a corporation generally may claim an offsetting deduction to the extent it receives dividends from a taxable resident corporation.  The deduction is not available for preferred shares more similar to debt than equity. A tax may be imposed on dividends on preferred shares if the corporation paying the dividend has not paid a minimum level of tax on the income generating the dividend.

Other Taxes

Each province imposes a provincial corporate income tax. Canadian municipalities may impose business license fees but do not impose income taxes. The provinces impose royalties or taxes on income from oil, gas, and mining operations.  The federal government imposes capital taxes on financial institutions and on life insurance corporations. The capital taxes effectively are a form of minimum tax, and income taxes and corporate surtaxes may be credited against them. Corporations generally may carry over unused credits from other years to reduce capital taxes due.

Canadian provinces also impose real estate taxes, typically at the municipal government level, and capital taxes on corporations with a permanent establishment in the province.

Inheritance And Gift Taxes

Though Canada imposes no gift or inheritance tax on its residents, deemed disposition provisions impose a form of such taxes. A person gifting property to another individual is deemed to have received proceeds equal to the fair market value of the gifted property, which may cause the donor to recognize income, recaptured depreciation, or capital gains. Similar rules apply to dispositions on death. Spouses may transfer property to each other either by gift or on death without trigging a deemed receipt of proceeds.

Payroll Taxes

Several Canadian provinces impose payroll taxes, which are used to finance social insurance programs. Employees must contribute, up to maximum annual limits, to a federal unemployment insurance fund and pension plan that provides retirement, disability, and certain other benefits. Every month, employers are responsible for collecting and remitting the employees’ portions, as well as their own portions.

The provinces each administer their own general health insurance and accident plans to assist residents with the cost of health care and to compensate employees who have been injured at work.

Indirect Taxes

Canada imposes a form of a value added tax known as the goods and services tax (“GST”). The tax generally applies to all domestic transactions, including certain transfers of real estate. The tax also applies to imported goods; imported services are subject to the tax if the service recipient is not registered for GST purposes. The GST is charged at each stage of the economic chain, and venders are able to claim refunds in the form of input tax credits of tax paid.

Because the final consumer is not able to claim an input tax credit for GST paid, the tax is ultimately borne by the final customer. The standard rate is six percent. Certain goods and services, such as food, medical devices, some agriculture and fishing products, residential rents, most health and dental services, certain educational services, domestic financial services, and the sale of previously owned residential housing, are exempt. Goods and services exported outside Canada are also exempt.

Several Canadian provinces impose a tax on transfers of real property.

Have a question on Tax Treaties? Contact Jason Freeman.

Mr. Freeman is the founding and managing member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney. Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service.
He was honored by the American Bar Association, receiving its “On the Rise – Top 40 Young Lawyers” in America award, and recognized as a Top 100 Up-And-Coming Attorney in Texas. He was also named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas” by AI.

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